The cool kids' table

"[Esther George] believed that by waiting longer to adjust the policy stance and deviating from the appropriate path to policy normalization, the Committee risked eroding the credibility of its policy communications."

"In addition, several expressed concern that an extended period of low interest rates risked intensifying incentives for investors to reach for yield and could lead to the misallocation of capital and mispricing of risk, with possible adverse consequences for monetary policy."

Esther, Esther, you're never gonna sit at the cool kids' table if you go on like that. Don't you know it's all about the decline in r* these days, and why the model says that if bond yields are low then the Fed's hands are tied? And if the data says that you ought to put rates up, the only prudent policy option is to wait for some data that says you oughtn't?

Macro Man suggested yesterday that Dudley's comments on the possibility of a September rate rise might be the opening gambit of a bait'n' switch, and so it's turned out to be thus far. Yesterday morning saw some heavy selling of the US front end, only to see prices reverse after the Fed declined to set the table for a September meeting...or any other meeting, for that matter. After the minutes there was a nice volte-face, with a candle suggesting more gains are in store. This is the reason that Macro Man now keeps a toaster in his bathroom; plugging it in and throwing it into the bath is less painful than trying to short the US front end (though he did manage to take back half of his post payroll Fed funds short on Tuesday, however.)

It says everything you need to know about modern monetary policy that a speech that Alan Greenspan gave two decades ago mentioning "irrational exuberance" is still well remembered, yet similar concerns about today's valuations are primarily expressed by regional presidents and confined to the back end of the minutes.

As has been well telegraphed, this year's Jackson Hole conference is dedicated to "Designing resilient monetary policy frameworks for the future." This is of course a laudable goal, although one does wonder if the current crop of central bankers is capable of achieving it. A robust and stable system or framework is one that recognizes its limits, a characteristic that has not been notable in many modern central bankers.

Macro Man had to laugh when he saw a chart of the latest Wu-Xia policy rate for the Eurozone, pictured below (hat tip @fwred). Now, one often hears the Wu-Xia model being cited in market circles, but Macro Man has grave doubts that many of the people citing it understand what it is doing. What it does not do is look at the panoply of macroeconomic information and say "here's where rates should be." Rather it uses forward rates as inputs. Well, guess what? Since the ECB moved to a negative depo rate, Eurozone forward rates have gone negative...which according to Wu-Xia means that rates should go even more negative! In other words, the very policy easing actions of the ECB have, according to this model at least, rendered policy more restrictive than if they'd done nothing at all.

Now, this is not to say that the ECB or anyone else are taking Wu-Xia seriously as a prescriptive policy recommendation- at least we can hope not. It does, on the other hand, clearly suggest that strange things happen when monetary policy enters the event horizon of ZIRP and NIRP. It also, incidentally, suggests limits to the utility of models as inputs to policy and economic decision making, as well as the folly of letting policy being led by the nose by market pricing.

As one commenter said yesterday of the Fed, "no one wants to hike rates and be responsible for a crash." Ironically, by doing nothing and letting market pricing of some financial instruments get so silly, they all will be responsible for the next crash, whenever it may be. In the meantime, they can sit at the cool kids' table and mock the nerdy worrywarts like the villains in an 80's teen flick.

The irony of course is that IF the 'wall of worry' exists for investors and affects their behaviour accordingly why wouldn't you accredit the same function to central bankers?. Indeed testing a few of these individuals for risk averse traits would be very interesting. Groundwork for a new recruitment requirement that applicants need above all to have a well balanced outlook on risk. I have to say Yellen appears by her behaviour to be so far to the risk averse end of the continuum that she barely fits on the continuum at all. Any risk in any part of the globe appears worthy of being acknowledged and let's face it do you ever remember a world where there was never some risk to be found ?

@MM regarding the irrational exuberance speech in 96 vs now - I am doing this back of the envelope, but back then the ratio of financial market cap (stocks + bonds globally) to world GDP was roughly 0.6:1 - now its 1.5:1, and I am not even including real estate - regardless of the beta you ascribe to the mechanism through which asset values impact consumer confidence and ultimately IP, no one can deny the real economy is much more at the mercy of valuations than ever before, so they are right to be worried - there are some good studies that would suggest that if the US economy got to say 1% growth, then the only difference between recession and muddle along would be the the stock market and whether it stayed bid.

Frankly to me its no mystery the Fed (and ECB and BoJ) are the market's bitch at this point - especially equities, since they don't directly impact it - whats abnormal is that market participants believe with near certainty that the fed's fear of the markets guarantees successful efforts in managing their outcome. This belief has always been around to some extent, but never with the kind of zealotry I witness these days.

It's interesting to me that the Fed mentioned the dangers of "incentives for investors to reach for yield" in the minutes, acknowledging what every man and his dog (who watches markets) has known for a while. Adding this to the BoJ's 'review' of monetary policy effectiveness and Carney's vow that the policy rate in the UK would not go negative, I am getting the impression that a change is afoot. Namely, that central bankers are beginning to openly acknowledge (even if implicitly) the limits of their ability to effect much change in the economy at this stage. This is quite a contrast with "whatever it takes".

Even if they remain ultra-cautious about rate hikes or removal of stimulus, the whiff of a new regime may have an impact on markets.

I am becoming more convinced that govt bond yields move higher from here, and certainly the asymmetry in possible returns is appealing. What I am struggling with is whether this will be disruptive for equity and other markets.

LB finds himself in agreement with this commentary from Marc Chandler, to the extent that when the FOMC Politburo, i.e. Dudley, Fischer and of course Yellen begin to show the claws, then one really needs to be cautious in buying the US front end and betting on a lower dollar. Thus Dudley's commentary this week (and the J-Hole speech by Yellen) are of more importance than Fed minutes.

We were in the Hammock and hence not wrong-footed by the minutes and the ensuing move in FX but we nevertheless began to add small strong dollar positions this morning (short AUDUSD, CADUSD and EURUSD) and will review later today and tomorrow. We agree with Nico G that there is going to be a bloody mess on the vol desks one day this Fall and therefore the desk that panics first (and starts buying its positions back earliest) will panic best. We have some small positions long vol.

November meeting seems unlikely for any number of reasons, so that leaves September and December for possible rate hikes. Underprice this possibility at your peril. Also remember that the Yellen Fed likes to telegraph its moves, so that if the September 20-21 meeting is to introduce a 25bp hike, we will have known about it for weeks in advance. This all points to Dame Janet's J-Hole speech as being of some significance this year, coming as it does a week or so before the latest jobs report. Another firm report with decent wage growth would surely provide Yellen the cover for a meager 25bp move.

"What I am struggling with is whether this will be disruptive for equity and other markets. "I'm not struggling with that if only because TINA has been the name of the song for so many that in effect their actions have been a function of the relative spreads available. As far back as Keynes the markets were described has a beauty contest and it is still true today that everything in the line has it's place based only upon it's relative attractiveness. Anything that changes those relative positions which I call spread reversal will be destructive to portfolios. I will qualify that last remark by acknowledging that if bond/equity spreads are disrupted because of policy changes rather than positive market economics (growth) then it will be wealth destructive.

I've called dollar weakness in august weeks ago, so far so good.Targeted levels are almost reached and a round of dollar strenght could/should be coming soon, probably when DXY enter the 93/94 area and euro 1.1350/1.1450.The importance of this likely dollar low remain to be seen, I tend to believe more weakness will come but working on a one month cycle, I will reassess during september.

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